1. AP Macroeconomics Unit 3: Aggregate Demand (AD), Aggregate Supply (AS) and Fiscal Policy

2. I. Aggregate Demand

4. What is Aggregate Demand?
Aggregate means “added all together.”
When we use aggregates, we combine all prices and all quantities.
Definition: Aggregate Demand is all the goods and services (real GDP) that buyers are willing and able to purchase at different price levels.
The Demand for everything by everyone in the US.
There is an inverse relationship between price level and Real GDP.
*If the price level:
Increases (Inflation), then real GDP demanded falls.
Decreases (deflation), the real GDP demanded increases.

5. Aggregate Demand Curve
AD represents the demand by domestic consumers, businesses, government, and foreign countries (nx).
*A change in any of these variables shifts the AD curve left or right!
Price
Level
What definitely doesn’t shift the curve?
Changes in price level cause a movement along the curve AD
= C + I + G + NX
Real domestic output (GDPR)

6. Why is AD curve downward sloping?
The Wealth Effect $$$$$$$$$
Higher price levels reduce the purchasing power of money, which decreases the quantity of expenditures.
Lower price levels increase purchasing power and increase expenditures.
Example:
If the balance in your bank was $50,000, but inflation erodes your purchasing power, you will likely reduce your spending.
So…Price Level (CPI inflation) goes up, GDP demanded goes down (movement along AD curve).

7. Why is AD downward sloping?
2. Interest-Rate Effect
When the price level increases, lenders need to charge higher interest rates to get a REAL return on their loans.
Higher interest rates discourage consumer spending and business investment. WHY?
Example: An increase in prices leads to an increase in the interest rate from 5% to 25%. You are less likely to take out loans to improve your business.
Result…Price Level goes up, GDP demanded goes down (and Vice Versa).
(movement along AD curve).

8. Why is AD downward sloping?
3. Foreign Trade Effect
When U.S. price level rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods
Exports fall and imports rise causing real GDP demanded to fall. (NX Decreases) (this is represented by a movement along AD curve).
Example: If prices triple in the US, Canada will no longer buy US goods, causing quantity demanded of US products to fall.
Again, Price Level goes up, GDP demanded goes down (and Vice Versa).

9. Determinants or Shifters of Aggregate Demand
GDP = C + I + G + NX
Holding Price Level Constant!!!!!

11. Shifters of Aggregate Demand
Change in Consumer Spending
Consumer Wealth (Boom in the stock market…)
Consumer Expectations (People fear a recession…)
Household Indebtedness (More consumer debt…)
Taxes (Decrease in income taxes…)
2. Change in Investment Spending
Real Interest Rates (Price of borrowing $)
(If interest rates increase…)
(If interest rates decrease…)
Future Business Expectations (High expectations…)
Productivity and Technology (New robots…)
Business Taxes (Higher corporate taxes means…)

12. Shifts in Aggregate Demand
An increase in spending shifts AD right, and decrease in spending shifts it left
Price
Level
AD1 AD
= C + I + G + NX
AD2
Real domestic output (GDPR) 12

13. Shifters of Aggregate Demand
Change in Government Spending
(War…)
(Nationalized Heath Care…)
(Decrease in defense spending…)
Change in Net Exports (X-M)
Exchange Rates
(If the us dollar depreciates relative to the euro…)
National Income Compared to Abroad
(If a major importer has a recession…)
(If the US has a recession…)
If dollar depreciates, more Europeans will buy US products causing Net Exports to increase
“If the US gets a cold, Canada gets Pneumonia”
AD = GDP = C + I + G + Xn 13

14. II. Aggregate Supply 14

15. What is Aggregate Supply?
Aggregate Supply is the amount of goods and services (real GDP) that firms will produce in an economy at different price levels.
The supply for everything by all firms.
Aggregate Supply will be differentiated between short run and long-run and has two different curves.
Short-run Aggregate Supply
Wages and Resource Prices will not increase/decrease as average price levels (inflation-deflation) increase/decrease.
Long-run Aggregate Supply
Wages and Resource Prices will increase/decrease as average price levels increase/decrease. 15

16. Short-Run Aggregate Supply
In the Short Run, wages and resource prices will NOT increase as price levels increase (inflation).
Example:
A firm currently makes 100 units that are sold for $1 each, and the only cost is $80 of labor.
How much is profit?
Profit = $100 - $80 = $20
What happens in the SHORT-RUN if price level doubles?
Now, 100 units sell for $2 each, so TR=$200.
Profit = $200 - $80 = $120
With higher profits, the firm has the incentive to increase production. All firms do… 16

17. Aggregate Supply Curve
Real domestic output (GDPR)

19. Long-Run Aggregate Supply
In the Long Run, wages and resource prices WILL increase as price levels (inflation) increase.
Same Example:
The firm has TR of $100 an uses $80 of labor.
Profit = $20.
What happens in the LONG-RUN if price level doubles?
Now TR=$200
In the LONG RUN workers demand higher wages to match prices. So labor costs double to $160
Profit = $200 - $160 = $40, but REAL profit is unchanged.
If REAL profit doesn’t change, the firm has no incentive to increase output. 19

20. Long run Aggregate Supply
In Long Run, price level increases but GDP doesn’t
LRAS
Price level
Full-Employment
Level of Output
(4-6% Unemployment
Trend Line)
Long-run
Aggregate
Supply QY
GDPR
We also assume that in the long run the economy will be producing at full employment. 20

21. Shifters of Aggregate Supply
I. R. A. P.

22. Shifts in Aggregate Supply
An increase or decrease in national production can shift the curve right or left
AS2
Price
Level AS
AS1
Real domestic output (GDPR) 22

23. Shifters of Aggregate Supply
Change in Inflationary Expectations
If an increase in AD leads people to expect higher prices in the future. This increases labor and resource costs and decreases AS.
(If people expect lower prices…)
B. Change in Resource Prices
Prices of Domestic and Imported Resources
(Increase in price of Canadian lumber…)
(Decrease in price of Chinese steel…)
2. Supply Shocks (usually oil)
(Negative Supply shock…)
(Positive Supply shock…) 23

24. Shifters of Aggregate Supply (NOT Government Spending—effects AD)
Change in Actions of the Government
(NOT Government Spending—effects AD)
Taxes on Producers
(Lower corporate taxes…)
Subsides for Domestic Producers
(Lower subsidies for domestic farmers…)
Government Regulations
(EPA inspections required to operate a farm…)
Change in Productivity
Technology
(Computer virus that destroy half the computers…)
(The advent of a teleportation machine…) 24

25. Practice 25

26. Answer and identify shifter: C.I.G.X or R.A.PB A D A D B A A C
A major increase in productivity. A 26

27. III. The AS and AD Model 27

28. Inflationary and Recessionary Gaps28

29. Example: Assume the government increases spending
Example: Assume the government increases spending. What happens to PL and Output?
LRAS
Price Level AS
PL and Q will Increase
PL1
PLe
AD1 AD QY Q1
GDPR 29

30. Inflationary Gap Output is high and unemployment is less than NRU LRAS
Price Level AS
Actual GDP above potential GDP
PL1
AD1 QY Q1
GDPR 30

31. Stagnate Economy + Inflation
Example: Assume the price of oil increases drastically. What happens to PL and Output?
LRAS
Price Level
AS1 AS
PL1
Stagflation
Stagnate Economy + Inflation
PLe AD Q1 QY
GDPR 31

32. Recessionary Gap Output low and unemployment is more than NRU LRAS
Price Level
AS1
Actual GDP below potential GDP
PL1 AD Q1 QY
GDPR 32

33. How does this cartoon relate to Aggregate Demand?33

34. AD and AS Practice Mankiw Packet34

35. Short Run and Long Run 35

36. Shifts in AD or AS change the price level and output in the short run
LRAS
Price Level AS
PLe AD QY
GDPR 36

37. Example: Assume consumers increase spending
Example: Assume consumers increase spending. What happens to PL and Output?
LRAS
Price Level AS
PL1
PLe
AD1 AD QY Q1
GDPR 37

38. Now, what will happen in the LONG RUN?
Inflation means workers seek higher wages and production costs increase
LRAS
Price Level
AS1 AS
PL2 C
Back to full employment with higher price level
PL1 B
PLe A
AD1 AD QY Q1
GDPR 38

39. AS increases as workers accept lower wages and production costs fall
Example: Consumer expectations fall and consumer spending plummets. What happens to PL and Output in the Short Run and Long Run?
Price Level
LRAS AS
AS1
AS increases as workers accept lower wages and production costs fall
PLe A
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment
PL1 B
PL2 C AD AD
AD1 Q1 QY
GDPR 39

40. A ratchet (socket wrench) tool forward but not backward.
The Ratchet Effect
A ratchet (socket wrench)
permits one to crank a
tool forward but not backward. 40

41. Does deflation (falling prices) often occur?
Not as often as inflation. Why?
If prices were to fall, the cost of resources must fall or firms would go out of business.
The cost of resources (especially labor) rarely fall because:
Labor Contracts (Unions)
Wage decrease results in poor worker morale.
Firms must pay to change prices (ex: re-pricing items in inventory, advertising new prices to consumers, etc.)
Like a ratchet, prices can easily move up but not down! 41

42. Classical vs. Keynesian
Adam Smith
John Maynard Keynes 42

43. Video: Classical vs. Keynesian view of the AS curve Episode 2543

44. Debates Over Aggregate Supply
Classical Theory
A change in AD will not change output even in the short run because prices of resources (wages) are very flexible.
AS is vertical so AD can’t increase without causing inflation. AS
Price level AD Qf
Real domestic output, GDP 44

45. Debates Over Aggregate Supply
Classical Theory
A change in AD will not change output even in the short run because prices of resources (wages) are very flexible.
AS is vertical so AD can’t increase without causing inflation. AS
Recessions caused by a fall in AD are temporary.
Price level
Price level will fall and economy will fix itself.
No Government Involvement Required AD
AD1 Qf
Real domestic output, GDP 45

46. Debates Over Aggregate Supply
Keynesian Theory
A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible.
Increase in AD during a recession puts no pressure on prices AS
Price level AD Qf
Real domestic output, GDP 46

47. Debates Over Aggregate Supply
Keynesian Theory
A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible.
Increase in AD during a recession puts no pressure on prices AS
Price level
“Sticky Wages” prevents wages from falling.
The government should increase spending to close the gap. AD
AD1 Q1 Qf
Real domestic output, GDP 47

48. Debates Over Aggregate Supply
Keynesian Theory
A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible.
Increase in AD during a recession puts no pressure on prices AS
When there is high unemployment, an increase in AD doesn’t lead to higher prices until you get close to full employment
Price level
AD3
AD2
AD1 Q1 Qf
Real domestic output, GDP 48

49. Three Ranges of Aggregate Supply
1. Keynesian Range- Horizontal at low output
2. Intermediate Range- Upward sloping
3. Classical Range- Vertical at Physical Capacity AS
Price level
Classical
Range
Keynesian
Range
Intermediate
Range
Qfull employment
Real domestic output, GDP 49

50. IV. The Phillips Curve
Shows tradeoff between inflation and unemployment.
What happens to inflation and unemployment when AD increase?

51. In general, there is an inverse relationship between unemployment rate and inflation rate51

53. Short Run Phillips Curve
When the economy is expanding or overheating, there is low unemployment but high inflation.
Inflation
When there is a recession, unemployment is high but inflation is low 5%
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1%
SRPC 2% 9%
Unemployment 53

54. Short Run Phillips Curve
What happens when AS falls causing stagflation?
There is an increases in unemployment and inflation.
Inflation 5%
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment
SRPC1 1%
SRPC 2% 9%
Unemployment 54

55. Long Run Phillips Curve
Short Run vs. Long Run
What happens when AD increases?
What happens in the long run?
Long Run Phillips Curve
Inflation
In the long run, wages and resource prices increase. AS falls. SRPC shifts right. 5% 3%
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment
SRPC1 1%
SRPC 2% 5% 9%
Unemployment 55

56. Short Run vs. Long Run Long Run Phillips Curve
In the long run, there is no tradeoff between inflation and unemployment.
Long Run Phillips Curve
Inflation 5%
The LRPC is vertical at the Natural Rate of Unemployment (4-6%). 3%
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1% 2% 5% 9%
Unemployment 56

57. What happens when AD falls? What happens in the long run?
Short Run vs. Long Run
What happens when AD falls?
What happens in the long run?
Long Run
Phillips Curve
Inflation 5%
In the long run, wages fall and there is no tradeoff between inflation and unemployment 3%
Short Run -AD Falls, PL and Q fall
Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment 1%
SRPC
SRPC1 2% 5% 9%
Unemployment 57

58. V. The Relationship Between the AS/AD Model and the Phillips Curve

59. AD/AS and the Phillips Curve
Show what happens on both graphs if AD increases
LRPC
Price Level
LRAS
Inflation AS I2
PL*2
PL* I*
AD1 AD
SRPC QY
Q*2
GDPR U2 UY
Unemployment 59

60. AD/AS and the Phillips Curve
Correctly draw the LRPC and SRPC with the recessionary gap. What happens when AD falls?
Price Level
LRAS
LRPC
Inflation AS
PLe I1
PL*2 I2 AD
SRPC
AD1
Q*3
Q*2 QY
GDPR UY U2 U3
Unemployment 60

61. AD/AS and the Phillips Curve
Correctly draw the LRPC and SRPC at full employment. What happens when AS falls?
Price Level
LRAS
LRPC
Inflation
AS1 AS
PLe
SRPC1 AD
SRPC QY
GDPR UY
Unemployment 61

62. AD/AS and the Phillips Curve
Correctly draw the LRPC and SRPC with a recessionary gap. What happens when AS increases?
Price Level
LRAS
LRPC
Inflation AS
AS1
PLe
SRPC AD
SRPC1 QY
GDPR UY
Unemployment 62

63. The Car Analogy The economy is like a car…
You can drive 120mph but it is not sustainable. (Extremely Low unemployment…economy overheating)
Driving 20mph is too slow. The car can easily go faster. (High unemployment)
70mph is sustainable. (Full employment)
Some cars have the capacity to drive faster than others. (industrial nations vs. 3rd world nations)
If the engine (technology) or the gas mileage (productivity) increase then the car can drive at even higher speeds. (Increase LRAS)
The government’s job is to brake or speed up when needed as well as promote things that will improve the engine. (Shift the PPC outward) 63

64. Actions by Congress and President to stabilize the economy.
How does the Government Stabilize the Economy?
The Government has two different tool boxes it can use:
1. Fiscal Policy:
Actions by Congress and President to stabilize the economy. OR
2. Monetary Policy: Actions by the Federal Reserve Bank to stabilize the economy. 64

66. Fiscal Policy--Videos66

67. Two Types of Fiscal Policy
Discretionary Fiscal Policy-
Congress creates a new bill that is designed to change AD through government spending or taxation.
Problem is time lags due to bureaucracy.
Takes time for Congress to act.
Ex: In a recession, Congress increases spending.
Non-Discretionary Fiscal Policy
AKA: Automatic Stabilizers
Permanent spending or taxation laws enacted to work counter-cyclically to stabilize the economy
Ex: Welfare, Unemployment, Min. Wage, etc.
When there is high unemployment, unemployment benefits to citizens increase consumer spending. 67

68. Expansionary Fiscal Policy (The GAS)
Contractionary Fiscal Policy (The BRAKE)
Laws that reduce inflation, decrease GDP (Close an Inflationary Gap)
Decrease Government Spending
Increase Taxes
Combinations of the Two
Expansionary Fiscal Policy (The GAS)
Laws that reduce unemployment and increase GDP (Close a Recessionary Gap)
Increase Government Spending
Decrease Taxes on consumers
Combinations of the Two
How much should the Government Spend? 68

69. They should NOT spend 100 billion!!!!!!!!!!
ID type of gap, and what type of policy is best?
What should the government do to spending? Why?
How much should the government spend?
LRAS
The government should increase spending, which would increase AD.
They should NOT spend 100 billion!!!!!!!!!!
If they spend 100 billion, AD would look like this: AS
Price level
WHY?
Let’s find
out. P1
AD2
AD1
$ $500
Real GDP (billions) 69 FE

70. VI. The Multiplier Effect
Why do cities want the Super Bowl in their stadium?
An initial change in spending will set off a spending chain that is magnified in the economy.
Example:
Bobby spends $100 on Jason’s product
Jason now has more income, so he buys $100 of Nancy’s product
Nancy now has more income, so she buys $100 of Tiffany’s product.
The result is a $300 increase in consumer spending
The Multiplier Effect shows how spending
is magnified throughout the economy. 70

71. Effects of Government Spending
If the government spends $5 Million, will AD increase by the same amount?
No, AD will increase even more as spending becomes income for consumers.
Consumers will take that money and spend, thus increasing AD.
How much will AD increase?
It depends on how much of the new income consumers save (or their marginal propensity to save vs their marginal propensity to consume).
If they save a lot, spending and AD will increase less.
If they save a little, spending and AD will increase a lot. 71

72. Marginal Propensity to Consume
Marginal Propensity to Consume (MPC)
How much people consume rather than save when there is a change in income.
It is always expressed as a fraction (decimal).
MPC=
Change in Consumption
Change in Income
Examples:
If you received $100 and spent $50.
If you received $100 and spent $80.
If you received $100 and spent $100. 72

73. Marginal Propensity to Save
Marginal Propensity to Save (MPS)
How much people save rather than consume when there is an change in income.
It is also always expressed as a fraction (decimal)
MPS=
Change in Saving
Change in Income
Examples:
If you received $100 and save $50.
If you received $100, your MPC is .7, what is your MPS? 73

74. Because people can either save or consume.
MPS = 1 - MPC
Why is this true?
Because people can either save or consume. 74

75. How is Spending “Multiplied”?
Assume the MPC is .5 for everyone
Assume the Super Bowl comes to town, and there is an increase of $100 in Ashley’s restaurant.
Ashley now has $100 more income.
She saves $50 and spends $50 at Carl’s Salon
Carl now has $50 more income
He saves $25 and spends $25 at Dan’s fruit stand
Dan now has $25 more income.
This continues until every penny is spent or saved 75

76. Calculating the Spending Multiplier
If the MPC is .5 how much is the multiplier?
Simple
Multiplier = or 1
MPS
1 - MPC
If the multiplier is 4, how much will an initial increase of $5 in Government spending increase the GDP?
How much will a decrease of $3 in spending decrease GDP?
MPC = .5 the multiplier is 2
Change in
GDP =
Multiplier x
initial change
in spending 76

77. = The Multiplier Effect or
Let’s practice calculating the spending multiplier.
Simple
Multiplier = or 1
MPS
1 - MPC
If MPC is .9, what is the multiplier?
If MPC is .8, what is the multiplier?
If MPC is .5, and consumption increased $2M. How much will GDP increase?
If MPC is 0 and business investment increases $2M. How much will GDP increase? 10 5
$4 million
$2 million
Conclusion: As the Marginal Propensity to Consumer falls, the Multiplier Effect is less 77

78. Fiscal Policy Practice
Congress uses discretionary fiscal policy to manipulate the following economy (MPC = .8)
LRAS
What type of gap?
Contractionary or Expansionary needed?
What are two options to fix the gap?
How much initial government spending is needed to close gap? AS
Price level P1
AD2
AD1
$100 Billion
$ $1000FE
Real GDP (billions) 78

79. Fiscal Policy Practice
Congress uses discretionary fiscal policy to the manipulate the following economy (MPC = .5)
LRAS
What type of gap?
Contractionary or Expansionary needed?
What are two options to fix the gap?
How much needed to close gap? AS P2
Price level
-$10 Billion
AD1 AD
$80FE $100
Real GDP (billions) 79

80. What about taxing? Expansionary Policy (Cutting Taxes)
The multiplier effect also applies when the government cuts or increases taxes.
But, changing taxes has less of an impact on changing GDP. Why?
Expansionary Policy (Cutting Taxes)
Assume the MPC is .75 so the multiplier is 4
If the government cuts taxes by $4 million how much will consumer spending increase?
NOT 16 Million!!
When consumers get the tax cut, consumers will save $1 million (MPS = .25) and spend $3 million (MPC = .75).
The $3 million is the amount magnified in the economy.
$3mill x 4 multiplier = $12 Million increase in consumer spending and GDP
.80

81. VII. Non-Discretionary Fiscal Policy81

82. Non-Discretionary Fiscal Policy AKA: Automatic Stabilizers
Legislation that acts counter-cyclically without explicit action by policy makers.
AKA: Automatic Stabilizers
The U.S. Progressive Income Tax System acts counter-cyclically to stabilize the economy.
When GDP is down, the tax burden on consumers is low, promoting consumption, increasing AD.
When GDP is up, more tax burden on consumers, discouraging consumption, decreasing AD.
The more progressive the tax system, the greater the economy’s built-in stability. 82

83. VIII. Problems With Fiscal Policy83

84. Problems With Fiscal Policy
When there is a recessionary gap what two options does Congress and President have to fix it?
What’s wrong with combining both?
Deficit Spending!!!!
A Budget Deficit is when the government’s expenditures exceed its revenues.
The National Debt is the accumulation of all the budget deficits over time.
If the Government increases spending without increasing taxes they will increase the annual deficit and the national debt.
Most economists agree that budget deficits are a necessary evil because forcing a balanced budget would not allow Congress to stimulate the economy. 84

85. Additional Problems with Fiscal Policy
Problems of Timing
Recognition Lag- Congress must react to economic indicators before it’s too late
Administrative Lag- Congress takes time to pass legislation
Operational Lag- Spending/planning takes time to organize and execute ( changing taxing is quicker)
Politically Motivated Policies
Politicians may use economically inappropriate policies to get reelected.
Ex: A senator promises more welfare and public works programs when there is already an inflationary gap. 85

86. Additional Problems with Fiscal Policy
3. Crowding-Out Effect
In basketball, what is “Boxing Out”?
Government spending might cause unintended effects that weaken the impact of the policy.
Example:
We have a recessionary gap
Government creates new public library. (AD increases)
Now consumers spend less on books (AD decreases)
Another Example:
The government increases spending, but must borrow the money (AD increases)
This increases the price for money (the interest rate).
Interest rates rise so Investments fall. (AD decrease)
The government “crowds out” consumers and/or investors 86

87. Additional Problems with Fiscal Policy
4. Net Export Effect
International trade reduces the effectiveness of fiscal policies.
Example:
We have a recessionary gap so the government spends to increase AD.
The increase in AD causes an increase in price level and interest rates.
U.S. goods are now more expensive and the US dollar appreciates…
Foreign countries buy less. (Exports fall)
Net Exports (Exports-Imports) falls, decreasing AD. 87

88. Please review the following in preparation for the MAC Unit #3 Test:
5-Steps to a 5, Chs: 13 & 14: AS & AD
Mankiw, Chs: 33, 34, 35
Mankiw Chapter 33, 34, and 35 Study Guides